Testing a related-party guarantee means first finding every guarantee the entity has given on behalf of a related party, from sources beyond the general ledger, then testing whether it was approved under the applicable Companies Act provisions, recognising its initial fair value as a financial liability where required, assessing the expected credit loss on the exposure the guarantee creates, and testing the disclosure of both the guarantee and the underlying related-party relationship. Because a guarantee not yet called generates no accounting entry on its own, this is a search-and-find procedure before it is a measurement procedure.
Why this needs active searching, not a confirmation checklist
A guarantee given on behalf of a subsidiary or associate typically surfaces in the lender's documentation for that subsidiary's loan, not in the guarantor's own books. If the audit relies on management representation alone, or on the guarantor's bank confirmation only covering its own direct facilities, a guarantee given to secure another entity's borrowing can go completely unflagged.
The testing sequence
- 01Request bank confirmations that specifically ask about guarantees given on behalf of third partiesA standard balance confirmation covering only the entity's own account balances will not surface this. The confirmation letter should explicitly ask the bank to disclose any guarantee, letter of comfort, or similar undertaking the entity has given in favour of any other party.
- 02Read the loan agreements and sanction letters of every related party audited, or ask the component auditorWhere a subsidiary or associate is audited separately, specifically ask that engagement team to confirm whether any of the subsidiary's borrowing is secured by a guarantee from the entity under audit.
- 03Read board and committee minutes for approvals of guarantees, letters of comfort, or security given for a related partyThese approvals are often minuted separately from the main loan discussion and can be missed if minutes are only skimmed for direct borrowing decisions.
- 04Test compliance with the applicable Companies Act provision governing guarantees and securityGuarantees given in connection with a loan to another body corporate are governed by the specific provisions on loans, guarantees and security, including the approval thresholds, interest rate conditions, and the register required to be maintained — test board and, where thresholds are crossed, shareholder approval against the amount and timing of the guarantee actually given.
- 05Recompute the initial recognition where the guarantee falls within scope of financial instruments recognitionA financial guarantee contract is initially measured at fair value, which for a guarantee given at arm's length for a fee is normally the fee received; for a guarantee given gratuitously to a related party with no fee, test whether the entity has appropriately considered the fair value of the guarantee obligation rather than recognising nothing at all.
- 06Assess the expected credit loss on the guarantee obligationA financial guarantee is subject to the same expected credit loss framework as other financial instruments, based on the credit risk of the related party whose obligation is guaranteed, not the credit risk of the guarantor itself.
- 07Test the disclosure as a contingent liability, a guarantee, and a related-party transaction, all threeThe guarantee should be disclosed under contingent liabilities with its amount and the party guaranteed, separately as a guarantee given in the relevant statutory note, and again under related-party disclosures, since each disclosure requirement serves a different reader and omitting one is not cured by including the others.
| Question | Evidence |
|---|---|
| Does the guarantee exist | Bank confirmation specifically covering third-party guarantees, loan agreement of the related party, board minutes |
| Was it properly approved | Board or shareholder approval tested against the applicable Companies Act thresholds |
| What is its initial measurement | Fee received, or a fair value estimate where given without a fee |
| What is the expected loss | Credit risk assessment of the underlying related party, not the guarantor |
| Is it fully disclosed | Contingent liability note, guarantee note, and related-party note, each separately |
A guarantee given to support a related party's borrowing, where that related party is itself in financial difficulty, is one of the more consequential off-balance-sheet exposures an audit can miss — it can sit entirely outside the financial statements right up until the related party defaults and the lender calls it.
How we think about this
Confirming whether a guarantee exists and tracing its approval is factual verification. Estimating its fair value and the expected credit loss it carries is a judgement about another entity's creditworthiness, made by the guarantor's auditor rather than that entity's own, and it deserves the same rigour as any other estimate built on someone else's financial position.
This is practical guidance written for audit teams, not an authoritative statement of any standard or statute. Standards, forms and timelines change. Check the current text issued by the ICAI and the relevant authority before relying on anything here in an audit file.
Related resources
- Bank, cash & treasuryBank guarantee verification in a statutory auditWhy BGs are off-balance-sheet contingent liabilities, confirming with the bank, tracking expiry, and verifying the margin money behind each one.
- Related parties & disclosuresHow to test related-party loan classification (loan vs advance vs investment)Read the actual terms of the arrangement rather than the label the client used, test repayment behaviour against those terms, and check the classification against what it actually triggers.
- CARO & Companies ActCARO clause 3(iv): compliance with sections 185 and 186How to test loans, investments, guarantees and security given by a company against sections 185 and 186 for CARO clause 3(iv) reporting.
- Audit documentationHow to test litigation contingency disclosures against the legal case fileGet the full legal case file independently of management's summary, test the probability and measurement judgement on each matter, and confirm it externally with counsel.
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